Cost of goods sold for small business is the cost of buying or making the products you sold during a period. It is one of the most important numbers in your books, because subtracting it from your sales gives you your gross profit. If it is wrong, your profit is wrong too.
This guide explains what cost of goods sold includes and leaves out, how to calculate it line by line, and the mistakes to avoid. It also includes a worked example with sample numbers.
What Is Cost of Goods Sold for Small Business?
If you make or buy goods to sell, you can deduct the cost of goods sold from your gross receipts. For sole proprietors, the IRS explains how to figure it in Publication 334, which walks through Part III of Schedule C. The result appears as a separate line on your profit and loss statement, above your operating expenses.
Cost of goods sold also connects to other parts of your books. It depends on your inventory, which our guide to small business inventory accounting explains. It also drives your gross margin, which our guide to small business profit margin covers.
Who Needs to Figure It
Businesses that make or buy products to sell need to figure cost of goods sold. If you only sell services, and selling merchandise is not an income-producing factor in your business, you generally do not figure it.
What Costs Count as Cost of Goods Sold for Small Business
Costs Usually Included
- Merchandise you buy for sale. Use the prices you actually paid, not the stated prices.
- Raw materials and supplies you use in production.
- Freight-in. Freight, express, and cartage charges on raw materials, production supplies, and merchandise you buy for sale are all part of cost of goods sold.
- Direct labor in manufacturing. This is the labor used to turn raw materials into a finished product.
- Certain manufacturing overhead. Examples include rent on a production building and depreciation of production equipment.
Labor costs are usually part of cost of goods sold only for manufacturing or mining businesses. Small merchandisers, such as retailers and wholesalers, usually do not have labor costs that belong in this calculation.
Costs Usually Not Included
- Selling and administrative expenses. Costs that are not chargeable to cost of goods sold can generally be deducted as selling or administrative expenses instead. Our guide to small business expenses covers these.
- Packaging that is not part of the product. If containers are not an integral part of the product, the IRS treats their cost as a shipping or selling expense.
- Your own pay. Do not include any amounts you pay yourself in cost of labor.
If you include a cost in cost of goods sold, do not deduct it again as a separate business expense.
How to Calculate Cost of Goods Sold for Small Business
In its simplest form, the formula is:
Cost of goods sold = Beginning inventory + Purchases + Labor + Materials and supplies + Other costs − Ending inventory
On Schedule C, Part III, the lines work like this.
Beginning Inventory
Enter the value of your inventory at the start of the year. It should normally match last year’s closing inventory. If it is different, attach an explanation.
Purchases
Enter the cost of the merchandise you bought for sale, and then make these adjustments:
- Use the prices you paid, after trade discounts.
- Account for cash discounts consistently. The IRS describes two methods: reduce your purchases by the discounts, or credit them to a separate discount account that you include in income at year-end.
- Subtract purchase returns and allowances.
- Subtract the cost of any items you took for personal or family use.
Cost of Labor
Include direct and indirect labor only if you manufacture goods. Do not include amounts paid to yourself.
Materials and Supplies
Include materials and supplies used in manufacturing goods.
Other Costs
Include costs such as freight-in, containers that are an integral part of the product, and allocable overhead expenses.
Add the Lines, Then Subtract Ending Inventory
Add the lines above to get the cost of goods available for sale. Then subtract your inventory at the end of the year. The remainder is your cost of goods sold.
Cost of Goods Sold for Small Business Example
Here is an example for a small retailer. These numbers are hypothetical.
- Inventory at the beginning of the year: $15,000
- Merchandise purchased at prices paid: $80,000
- Purchase returns and allowances: $2,000
- Items taken for personal use: $500
- Cost of labor: $0 (a retailer usually has none)
- Materials and supplies: $0
- Other costs, freight-in: $1,500
- Inventory at the end of the year: $12,000
Purchases, net: $80,000 − $2,000 − $500 = $77,500
Cost of goods available for sale: $15,000 + $77,500 + $1,500 = $94,000
Cost of goods sold: $94,000 − $12,000 = $82,000
Cost of Goods Sold and Gross Profit
For a business that sells products, gross profit is net receipts minus cost of goods sold. Net receipts are gross receipts after returns and allowances.
Continuing the example, suppose gross receipts were $125,000 and sales returns and allowances were $5,000:
- Net receipts: $125,000 − $5,000 = $120,000
- Gross profit: $120,000 − $82,000 = $38,000
- Gross profit margin: $38,000 ÷ $120,000, or about 31.7%
Common Cost of Goods Sold Mistakes
- Counting your own pay as labor. The IRS says not to include amounts paid to yourself.
- Using stated prices instead of prices paid. Trade discounts reduce your cost.
- Forgetting freight-in. It belongs in cost of goods sold, not in general expenses.
- Leaving out returns and personal withdrawals. Both reduce your purchases.
- Deducting the same cost twice. A cost in cost of goods sold cannot also be a separate expense.
- Mixing selling costs into cost of goods sold. Keep selling and administrative expenses separate.
- Using a wrong ending inventory. An error in ending inventory flows straight into your cost of goods sold and your profit.
Keeping Good Records
Accurate cost of goods sold starts with good bookkeeping. Keep your purchase invoices, track freight-in separately from other expenses, and count your inventory regularly. Our guide to small business bookkeeping explains how to keep your records organized.
Frequently Asked Questions
What is cost of goods sold?
It is the cost of buying or making the products you sold during a period, including items like merchandise, materials, freight-in, and direct labor in manufacturing.
How do you calculate cost of goods sold?
Add your beginning inventory, net purchases, and any labor, materials, and other costs. Then subtract your ending inventory.
Does a service business have cost of goods sold?
Generally not, if selling merchandise is not an income-producing factor in the business.
Is shipping part of cost of goods sold?
Freight-in on merchandise, materials, and supplies you buy is part of cost of goods sold. Packaging that is not an integral part of the product is treated as a shipping or selling expense.
Can I include my own salary in cost of goods sold?
No. On Schedule C, the cost of labor line says not to include any amounts paid to yourself.
What is the difference between cost of goods sold and operating expenses?
Cost of goods sold covers the direct costs of the goods you sold. Selling and administrative costs that are not chargeable to cost of goods sold are deducted separately as expenses.
Conclusion
Understanding cost of goods sold for small business helps you see what your products really cost and how much you keep from each sale. Include the right costs, leave out your own pay and selling expenses, and keep your inventory records accurate. Review the IRS guidance for your situation and talk with a tax professional if you are unsure. This guide is general information, not tax advice.